We find ourselves in an environment of low interest rates as a result of the global financial crisis and the subsequent actions of global central banks to try and stimulate faltering economies. If you are borrowing money as a company and in some cases as an individual it may feel like a wonderful period as borrowing costs have rarely been cheaper.

However, if you have been diligently saving and doing what you are supposed to in order to provide for your income long after retirement, the current environment is likely to be devastating your investment returns and wreaking havoc with your savings plan.

Those that are in retirement and near retirement are very much on the receiving end of this set of circumstances as they already rely on their savings to provide an income.

What should we be seeking as investors?

Investors should be concerned with achieving real returns which means maintaining the purchasing power of their money. R100 today will not necessarily buy you the same amount of a good or service in a one year’s time. We only need to go past the petrol pump these days to see how inflation or a general increase in price levels eats away at the contents of your wallet. 

A real return is usually associated with a return in excess of inflation but the REAL real return should also consider taxes and investment management fees, as in truth all three of these factors influence what is leftover in the investment pot for future income generation purposes. *

Current inflation rates as measured by the Consumer Price Index (CPI) across various geographic regions are:

Source: www.tradingeconomics.com as at July 2012

What asset classes currently deliver real returns?

The options for earning real returns have dwindled in number post crisis. Not only are investment returns lower but in many countries inflation has crept higher largely as a result of higher food and energy prices. The current artificial monetary stimulus measures and easy money are likely to result in even higher inflation in the years ahead making the outlook for real returns even less certain.

Higher real returns are typically associated with exposing your capital to greater day-to-day swings in the market value of your investments. However we believe it is wrong to consider this as necessarily higher risk. The so called risk-free assets (cash and government bonds) that deliver negative real returns carry the risk of not maintaining your purchasing power over the long term which can have the same impact as a reduction in your capital value over time. 

Summary table of possible yields (Click on a Asset class name below for further detail):

Source: *tradingeconomics.com, ** ft.com+moonstone, ^ wsj.com, ^^ wsj.com + investorintelligence.com, ~ft.com,~~ Total return index from Morningstar LTM to end August (i.e. not comparable to all the others which show an income yield). As at 31 August 2012

The different asset classes do not typically respond to economic conditions in the same way. Each of these income options should be considered in the context of these factors:

Risk to capital – This means the likelihood that you will see fluctuations in the value of your original investment amount as a result of short term moves in market prices.

Real Returns – This means the return we are likely to receive in excess of inflation as defined above. These return expectations are usually inferred by recent past performance and existing yields but it must be noted that past performance is not an indication of future performance.

Investment time horizon – This relates to the amount of time you should consider holding the investment in order to realistically achieve the type of returns each asset class is supposed to deliver. Short term market moves can deviate significantly from expectations particularly in the current environment where macro concerns are dominating sentiment rather than any fundamental valuation measures.

Liquidity – This pertains to the ability to easily enter (buy) or exit (sell) your investments without incurring prohibitive transaction costs. The global crisis of 2007/2008 clearly illustrated how some asset classes can become very difficult to trade at time of severe distress. .

Investment options –This refers to the type of products available to investors looking to gain exposure to specific asset classes.

Tax – Income in the form of interest and or rental income are in most cases taxed at your marginal rate of tax. Capital gains tax is usually taxed at a lower rate and often subject to a capital gains tax allowance. Returns on assets held in a retirement plan (pension, provident or annuity) are tax free until you start to draw an income in retirement . You should consult a tax specialist for a full assessment specific to your personal circumstances.

Cash Deposits:

Interest rates are at all time lows. Any money sitting in the bank is likely to be earning less than this in most instances.

Conclusion: Not an attractive investment option but it is the only option if you are averse to any capital losses as a result of market price changes.

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Money Markets:

Money markets officially mean investments with a maturity of less than 1 year. Examples are certificates of deposit issued by companies who wish to access very short term funding.

Conclusion: Not an attractive investment option but it should provide a higher return than a cash deposit as your money will be lent at longer maturities and will have some credit risk associated with it.

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Government bonds:

Government bonds represent loans made to governments for which they pay you a pre-determined (usually fixed) income or coupon. The yields paid vary depending on the financial and political stability of the issuing country. The longer you loan money for the higher the yield you should expect to receive annually as it is riskier to lend for extended periods because in essence there is more time for things to go wrong.

Conclusion: Not attractive. While the yields are higher than cash and money markets even the longer term 10 year bonds for developed government bonds do not currently provide real returns. As interest rates come down so do government bond yields and fear over the global economy have seen ‘safe haven’ flows into UK Gilts, US Treasuries and German Bunds exacerbating the low yields.

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Corporate bonds:

Corporate bonds represent loans made to companies for which they pay you a pre-determined (usually fixed) income or coupon. The yields paid vary depending on the financial strength and stability of the issuing company.

Although not a fool-proof system of classifying risk within corporate bonds, the rating agencies ascribe a rating to corporate issuers that infer the credit risk associated with each company on the basis of probability of default and the loss given default. Investment Grade ratings refer to bond with a BBB minus or higher rating and are less risky than High Yield corporate bonds which have ratings of BB+ and lower.

Maturities of bonds also influence the yield you will receive – longer dated bonds should pay you a higher return than their shorter dated counterparts.

Conclusion: Corporate bonds are likely to offer you a real return even if you invest in the safer and higher quality sectors of the market.  You should be aware however that corporate bonds are priced off the underlying government bond market so are subject to the same significant risks of a rise in interest rates in the years ahead.

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Equities or Shares:

Unlike corporate bonds, which are merely loans to companies at the end of which you get your money back (maturity), when you buy shares you are buying an ownership interest in that company. You are therefore entitled to your portion of earnings and dividends if the companies you own see fit to pay out an income. Coupons on bonds are a contractual obligation in most cases whereas a dividend on a share is completely at the discretion of the company management and may be stopped, reduced or increased at will. This means your income is generally less certain when investing in equities.

Conclusion: Shares represent the asset class most likely to deliver a positive real return over the medium to long term given the current low yield environment we find ourselves in. Many investors are averse to investing in equities as the risk to the initial capital is deemed to be too high. This may be true in the short term but investors should be wary of taking too short-term an approach without regards for the relative value of equities versus other asset classes. You can mitigate the downside risk to capital by buying high quality companies at attractive valuations with good dividend yields and be willing to ride some of the shorter term fluctuations.

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Indirect Property:

Holding property investments need not involve your physical ownership of a residential or commercial property. There are ways to access this asset class through listed companies who specialise in managing a portfolio of properties and pay out a proportion of the rental income to the owners or shareholders.

Conclusion: Attractive from the perspective of delivering real returns but it may not be wise to throw all of your money into this asset class alone given the high correlation in times of distress and the potential for low liquidity to hamper the easy conversion to cash as and when needed.

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Definitions:

Credit risk – this is the risk that the counterparty you have loaned the money too is unable to repay you in full. This risk is typically lower the shorter your investment period and is lower the better quality the balance sheet of the entity you loan to.

Basis Point – This is a common term used when talking about fractions of a percentage point. There are 100 basis points (bps) in 1%. So 10bps = 0.1%

Default – In bond language this refers to the failure of a company or issuer to fulfil its obligations to pay you a coupon/income and to return to you all of capital when the bond matures.

Loss given default – In bond language this refers to the amount of money you are likely to lose if your bonds default. It is related to what is known as the recovery rate or the amount of money as a proportion of your initial investment you are likely to get once the company is liquidated or restructured.

*Trying to structure your investments as tax efficiently as possible is an important consideration and you should never underestimate the impact of fees on your overall returns as these can be very significant indeed. Since fees and taxes depend on various factors (the savings vehicle you use, the product you invest in, the source of returns and your tax bracket), it is simpler to use the definition that relates real returns to inflation alone.

Please note this write-up does not constitute advice. Please contact White Investments if you would like more information and insight into the various options discussed above.